Case of the Week

Exit Strategies for Real Estate Investors, Part 4

Case:

Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.

Amazingly, Karl continued to buy and sell real estate at the age of 85. For instance, about three months ago, Karl discovered a great investment property. It was a "fixer-upper" commercial building in a great area. While other nearby buildings sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.

The condition of the building turned many buyers away. It was being sold "as-is," but Karl was not deterred. He could see great potential with the building and knew it would not take much to get it to market condition. Therefore, Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.

After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl. He knew the building was a great buy.

After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. (See Parts 1 and 2 for a full discussion of this decision.) It looked like the perfect solution.

Question:

However, there was still one issue unresolved. There was a $100,000 debt on the property that Karl incurred at the time of purchase. Thus, he wanted to know what effect, if any, the $100,000 mortgage would have on the FLIP CRUT plan.

Solution:

Karl's situation is not an uncommon situation. Indeed, the majority of real estate is encumbered by some amount of debt. Unfortunately, mortgaged real estate and CRTs generally do not mix well. The transfer of debt-encumbered property into a CRT triggers two potential problems: 1) grantor trust status that results in disqualification of the trust, and 2) debt-financed income that subjects the trust to a 100% tax on unrelated business taxable income (UBTI).

If the debt obligation is solely against the property, the debt is termed "nonrecourse." If the obligation is against both the property and the owner personally, the debt is termed "recourse." The IRS states that the transfer of recourse debt into a CRT will reclassify the trust as a grantor trust. See PLR 9015049. Since a CRT cannot be a grantor trust, the trust will cease to qualify as a CRT.

If the debt is deemed nonrecourse, then there is no personal liability under Sec. 677 and, accordingly, no grantor trust status problem. Thus, in the event of nonrecourse debt, it may be permissible to transfer the real estate into the CRT without disqualifying the trust.

However, in nearly all cases real estate debt is recourse. Nevertheless, it is important to verify the nature of the debt. Therefore, after contacting his lender, Karl learns that he is personally liable for the debt (i.e., the debt is recourse debt). Therefore, he knows this poses a significant problem, since his FLIP CRUT cannot safely accept the gift of real estate now.

Even if the debt were nonrecourse, to avoid a debt-financed income problem to the CRT it is imperative that the mortgaged property pass the "5 and 5" rule. Simply put, the nonrecourse debt needs to be more than five years old and the property owned for more than five years. (For a review of the "5 and 5" rule, see GiftLaw Pro 2.1.2.) If the "5 and 5" rule is not met, then the CRT may have debt-financed income (i.e., UBTI) upon sale of the property. If this occurs, then part of the CRT income is taxable. Because UBTI is subject to a 100% excise tax, this would largely deplete the trust. Accordingly, debt-financed income inside a CRT should be avoided at all costs.

To make matters worse, Karl also fails the "5 and 5" rule because the debt is not even one year old, much less five years old. Thus, Karl is dealing with a second significant problem, since debt-financed income will subject the trust to huge taxation.

Karl now realizes that his $100,000 mortgage poses a double dip of disaster. Karl's options for proceeding with his FLIP CRUT plan will be discussed in Part 5.